What are Barriers to Entry?
Barriers to entry are the economic term describing the existence of high start-up costs or other obstacles that prevent new competitors from easily entering an industry or area of business. Barriers to entry benefit existing firms because they protect their revenues and profits.
Common barriers to entry include special tax benefits to existing firms, patents, strong brand identity or customer loyalty, and high customer switching costs. Others include the need for new firms to obtain proper licenses or regulatory clearance before operation.
[Important: barriers to entry may be natural (high startup costs to drill a new oil well), created by governments (licensing fees or patents stand in the way), or by other firms (monopolists can buy or compete away startups).]
Barriers to Entry
How Barriers to Entry Work
Some barriers to entry exist because of government intervention, while others occur naturally within a free market. Often, industry firms lobby for the government to erect new barriers to entry. Ostensibly, this is done to protect the integrity of the industry and prevent new entrants from introducing inferior products into the marketplace. Generally, firms favor barriers to entry when already comfortably ensconced in an industry to limit competition and claim a larger market share. Other barriers to entry occur naturally, often evolving over time as certain industry players establish dominance. Barriers to entry are often classified as primary or ancillary. A primary barrier to entry presents as a barrier alone (e.g. large startup costs). An ancillary barrier is not a barrier alone; rather, combined with other barriers, it weakens the potential firm's ability to enter the industry. It serves as a reinforcement to other barriers.
- Barriers to entry are the economic term describing the existence of high start-up costs or other obstacles that prevent new competitors from easily entering an industry or area of business.
- Barriers to entry benefit existing firms because they protect their revenues and profits.
- Barriers to entry may be caused naturally, by government intervention, or through pressure from existing firms.
- Each industry has its own specific set of barriers to entry that startups must contend with.
Government Barriers to Entry
Industries heavily regulated by the government are usually the most difficult to penetrate; examples include commercial airlines, defense contractors, and cable companies. The government creates formidable barriers to entry for varying reasons. In the case of commercial airlines, not only are regulations stout, but the government limits new entrants to limit air traffic and simplifying monitoring. Cable companies are heavily regulated and limited because their infrastructure requires extensive public land use.
Sometimes the government imposes barriers to entry not by necessity but because of lobbying pressure from existing firms. For example, in many states, government licensing is required to become a florist or an interior decorator. Critics assert that regulations on such industries are needless, accomplishing nothing but limiting competition and stifling entrepreneurship.
Natural Barriers to Entry
Barriers to entry can also form naturally as the dynamics of an industry take shape. Brand identity and customer loyalty serve as barriers to entry for potential entrants. Certain brands, such as Kleenex and Jell-O, have identities so strong that their brand names are synonymous with the types of products they manufacture.
High consumer switching costs are barriers to entry as new entrants face difficulty enticing prospective customers to pay the additional money required to make a change/switch.
Industry-Specific Barriers to Entry
Industry sectors also have their own barriers to entry that stem from the nature of the business as well as the position of powerful incumbents.
Before any company can make and market even a generic pharmaceutical drug in the United States, it must be granted a special authorization by the FDA. These Abbreviated New Drug Applications, or ANDAs, are hardly abbreviated; estimates in 2006 suggested the average time for a decision was 17 months. Moreover, some 93% of applications are not approved in the first cycle and of those, 66% are not approved in the second review. Each application is incredibly political and even more expensive. In the meantime, established pharmaceutical companies can replicate the product awaiting review and then file a special 180-day market exclusivity patent, which essentially steals the product and creates a temporary monopoly.
As Forbes reported in 2012, the average cost of bringing a new drug to market was between $1.3 billion and $4 billion. Costs could be as high as $11 billion to $12 billion. A single clinical trial could cost as much as $100 million, and the FDA usually approves about one in 10 clinically tested drugs. Just as significantly, it can take up to 10 years for a drug to be approved for prescription. Even if a startup company had the $4 billion to develop and test the drug according to FDA rules, it still might not receive revenue for 10 year
Consumer electronics with mass popularity are more susceptible to economies of scale and scope as barriers. Economies of scale mean that an established company can easily produce and distribute a few more units of existing products cheaply because overhead costs, such as management and real estate, are spread over a large number of units. A small firm attempting to produce these same few units must divide overhead costs by its relatively small number of units, making each unit very costly to produce.
Established electronics companies, such as Apple, may strategically build in switching costs to retain customers. These strategies may include contracts that are costly and complicated to terminate or software and data storage that cannot be transferred to new electronic devices. This is prevalent in the smartphone industry, wherein consumers may pay termination fees and face the cost of reacquiring applications when they consider switching phone service providers.
Oil & Gas Industry
The barriers to entry in the oil and gas sector are extremely strong and include high resource ownership, high startup costs, patents and copyrights in association with proprietary technology, government, and environmental regulations, and high fixed operating costs. High startup costs mean that very few companies even attempt to enter the sector. This lowers potential competition from the start. In addition, proprietary technology forces even those with high startup capital to face an immediate operating disadvantage upon entering the sector.
High fixed operating costs make companies with startup capital wary of entering the sector. Local and foreign governments also force companies within the industry to closely comply with environmental regulations. These regulations often require capital to comply, forcing smaller companies out of the sector.
Financial Services Industry
It is generally very expensive to establish a new financial services company. High fixed costs and large sunk costs in the production of wholesale financial services make it difficult for startups to compete with large firms that have scale efficiencies. Regulatory barriers exist between commercial banks, investment banks, and other institutions and, in many cases, the costs of compliance and threat of litigation are sufficient to deter new products or firms from entering the market.
Compliance and licensure costs are disproportionately damaging to smaller firms. A large-cap financial services provider does not have to allocate as large of a percentage of its resources to ensure it does not run into trouble with the Securities and Exchange Commission (SEC), Truth in Lending Act (TILA), Fair Debt Collection Practices Act (FDCPA), Consumer Financial Protection Bureau (CFPB), Federal Deposit Insurance Corporation (FDIC) or a host of other agencies and laws.